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Doo Doo 32 Bank Drill Down 1.5: The Forensic Analysis of Wells Fargo

This is the forensic continutation of the summary overview of Wells Fargo (Doo-Doo bank drill down, part 1 - Wells Fargo), as well as part 18 of Reggie Middleton on the Asset Securitization Crisis. The other published parts are as follows...

Now, the Forensic Summary Wells Fargo to be followed by the full report. Registered members of the blog can download a PDF version here.

Significant exposure to real estate, construction and home equity
loans– Wells Fargo’s loan portfolio has
significant exposure to the distressed real estate, construction and home
equity loans. With rising defaults and foreclosures, due to declining prices,
the bank’s US$18.8-billion real estate construction loan portfolio and US$83-billion
home equity portfolio will likely be under severe pressure, resulting in higher
NPAs. In addition, Wells Fargo has huge exposure to the troubled housing
markets of California and Florida that have been at the forefront of the
current housing slump. These two states account for 20.3% of the bank’s real
estate and construction loan portfolios, one of the highest for a major
financial institution in the US.

Slowing housing market, worsening
macroeconomic conditions to result in higher defaults – The sluggishness in the US housing market, declining
prices, rising foreclosures and inventory pile up are likely to have a negative
impact on the bank’s loan portfolio. Higher deliniquencies in the US mortgage
market could increase losses. In addition, the rising unemployment rate and
higher inflation would further restrict consumer spending in the US. These
developments are likely to increase defaults across all asset catergories.

Problems in home equity portfolio to
resurface as maximum exposure is in most troubled markets - Despite avoiding riskier loans, such as ARMs, Wells
Fargo’s home equity portfolio continues to

deteriorate. The
bank segregated US$11.5 billion of home equity loans into a liquidating
portfolio, representing approximately 3% of total loans outstanding in 1Q 08.
In addition, nearly 45% of the US$72.1-billion core home equity portfolio,
representing nearly 70% of the bank’s shareholders’ equity in 1Q 08, was in the
states of California (accounted for 36% of the portfolio), Florida (4%) and
Arizona (5%) – the most affected real estate markets in the US.

Higher
NPAs and charge-offs - The bank’s non-performing
assets (NPAs) have been rising consistently, up 22% q-o-q to US$3.3 billion in
1Q 08. On a y-o-y basis, the NPAs increased 86%. NPAs as a percentage of total
loans rose from 0.54% in 1Q 07 to 0.84% in 1Q 08 due to deteriorating real
estate construction and home equity portfolios.

Provisions for losses likely to increase
in coming quarters– The bank’s
provisions for losses have not kept pace with the growth in its loan portfolio.
Wells Fargo’s allowance as a percentage of loans declined from 2.86% in FY 1998
to 1.18% in FY 2006. The bank’s loans increased at a CAGR of 14.3% to US$382
billion in the last nine years, while the provision for losses expanded at a
CAGR of 5.5% to US$5.3 billion. Higher provisioning is likely to have a severe
impact on its bottom-line in the coming quarters.

We value Wells Fargo at US$16.02 per
share, 37% lower than the current market price - To value Wells Fargo, we have used the Discounted Cash Flow
(DCF), Price-to-Adjusted Book Value (P/ABV), Price-to-Sales (P/S), and Price-to-Earnings
(P/E) multiple methods. Based on our weighted average valuation, we arrived at
a fair value of US$16.02, which represents a 37% downside from the current
level of US$25.27 per share.

Investment Summary

Wells Fargo & Company (WFC) is one of the largest US banks with significant
exposure to the troubled residential and commercial real estate markets,
primarily through its home equity loan portfolios that continue to deteriorate
at a brisk pace. Wells Fargo’s substantial engagement in real estate
construction lending activities, which expose it to significant losses and is
the primary reason behind its higher charge-offs thus far. The ongoing credit
crisis, sparked by the US subprime mortgage meltdown, is more a function of lax
underwriting practices followed by banks and the asset securitization fiasco.
The increase in bankruptcies infiasco, thus it is safe to assume that we will
see a cascading domino effect ripple through WFC’s suspect lending portfolio,
expanding beyond subprime mortgages and residential lending. The rising defaults
in the subprime mortgage markets and rising foreclosures in the housing market marked
the beginning of the crisis. Wells Fargo has more than a significant exposure
toward the real estate and housing sector as a majority of its lending
activities are confined to these sectors. With the current asset securitization
crisis showing no signs of abating, the bank will be forced to keep these
noxious creations on its books and will assuredly have to take heftyfurther, and
more significant charge-offs on its loan portfolio, going forward.

The decline in housing prices, rising foreclosures and inventories along
with the slowdown in demand are leading to defaults in the housing market.
Moreover, the impact is likely to be felt more strongly in Wells Fargo’s case compared
to other commercial banks in the US, since it has concentrated exposure to the
most troubled housing markets of California and Florida that have been at the
forefront of the current housing slump. These two states account for 20.3% of the
bank’s total real estate and construction loan portfolio, one of the highest
for a major financial institution in the US. In addition, nearly US$12 billion
of the bank’s home equity portfolio, worth US$12 billion, (15%) has been put on
liquidation. This liquidation, is also likely to result in huge losses in the coming
quarters. The bank will likely be required to increase provisions in the next
few quarters as losses unfold in its loan portfolio, which will increase downward
pressure on earnings. The bank’s net interest income is anticipated to remain
stable as long as the recent interest rate cuts by the US Federal Reserve likely
to bringremain intact, thus bringing down the borrowing cost. Unfortunately for
WFC, as well as many other banks who have marginally profitable operations, the
loose monetary policy of the recent past has stoked inflationary fires across
the globe and has caused a worldwide push to urge the US to strengthen the
dollar, which will inevitably result in higher interest rate targets from the
Federal Reserve Bank. In addition, non-interest income is expected to come
under pressure as income from the credit card and mortgage banking businesses
is likely to decline, as macroeconomic conditions and the consumer balance
sheet and confidence continue to worsen.

Key Investment Points

Significant exposure to real estate,
construction and home equity loans to result in writedowns in coming quarters

Wells Fargo’s loan portfolio has significant exposure to distressed
real estate, construction and home equity loans. The bank’s total loan
portfolio, valued on its books at US$386 billion, is comprised of commercial
real estate loans of US$156 billion, consumer loans of US$222 billion and US$7
billion of foreign loans. The bank has US$18.8 billion of exposure to real
estate construction and development loans that have expanded at a CAGR of 27.8%
over the last three years. Wells Fargo’s exposure to the real estate
construction sector is the fourth-largest among all US banks, in absolute
amount terms.

The bank’s real estate construction loans are expected to come under
severe stress as the slump in housing demand and the decline in housing prices continue
to exert significant pressure on the real estate sector. Housing demand has been
steadily decreasing while supply is riding the upward wave from builders
attempting to monetize depreciating assets, banks flipping REOs back on to the
street at highly discounted prices, and existing homeowners cling to last
year’s pricing – as we see it, housing prices will continue to remain in the ‘correction’
mode until affordability reaches pre-boom levels. The US annual housing starts
declined almost 25% in 2007, following the 13% fall in 2006. In addition, home
prices continue to drop quarter after quarter. The Office of Federal Housing
Enterprise Oversight (OFHEO)’s home price index recorded the largest y-o-y
decline in the last 17 years, plunging 3.1% in 1Q 08. The states of California,
Nevada and Florida reported the steepest y-o-y drop in home prices. Wells Fargo,
with large construction loans exposure in all of those regions, is highly likely
to be negatively impacted.

Wells Fargo’s Loan Portfolio

Source: Company data

The bank’s real estate construction loans are under considerable stress—the non-performing assets (NPAs) to loan ratio stood
at 2.32% in 1Q 08. NPAs in real estate construction loans increased to US$438 million
in 1Q 08 from US$82 million in 1Q 07 and US$293 million in 4Q 07. California accounted for nearly 32.1% of the
total real estate construction loans, while
Arizona and Florida accounted for 6.7% and 4.8%, respectively. In addition, the bank has US$38 billion of
other real estate loans under the commercial and commercial real estate loans;
nearly US$13.9 billion other real
estate loans are concentrated in the
state of California.Housing
prices in California have declined significantly and continue to be on a downtrend.
According to OFFHEO, housing prices in this state fell 10.6% in 1Q 08, followed
by Nevada (10.3%), Florida (8.1%), Arizona (5.5%), and Michigan (3.1%). Considering
the bank’s large exposure to these troubled markets, its NPAs in the commercial
and commercial real estate portfolio are bound to rise, going forward.

Real estate construction loans and NPAs

Source: Company data

Wells Fargo has US$148 billion in 1-4 family mortgages that represent
approximately 38% of the total loans. Around US$49 billion of the total loans
is in the state of California, US$6 billion in Florida and US$7 billion in
Minnesota. The building permits in California, Florida and Minnesota declined
61%, 46.8% and 47.5%, respectively, in 1Q 08. This is likely to exert further pressure
on the loan portfolio. Consumer loans consist of US$148 billion single family
mortgages, US$18.6 billion in credit card loans and US$55 billion of other
revolving credit and installments. In the last few quarters, the bank increased
the charge-offs on this portfolio, which is the worst hit after the real estate
construction loan portfolio. NPAs in the real estate 1-4 family first mortgages
rose to 1.91% in 1Q 08 from 1.25% in 1Q 07 and 1.78% in 4Q 07, due to increased
defaults in mortgages and rising delinquencies. The worsening trend of NPAs reflects
Wells Fargo’s exposure to the troubled markets and the uptrend in defaults
across all loan categories.

Wells Fargo’s Real Estate 1-4 family lien mortgage

Source: Company data

Slowing housing market to increase
Wells Fargo’s problems

The decline in the US residential and commercial real estate markets,
owing to the slump in demand, has resulted in huge writedowns and credit losses
across the banking and financial services sectors. Housing starts have been
falling consistently and recorded a decline of 38.7% in 1Q 08. The sluggishness
in the housing market is exerting pressure on the valuation of asset-backed and
mortgage-backed securities. In addition, the sharp correction in housing prices
witnessed across almost all states in the US is aggravating the woes, causing further
deterioration. The increase in housing inventories, following the rise in
foreclosures, is expected to put more downward pressure on the value of the
housing portfolio.

According to the Mortgage Bankers Association (MBA)’s latest National
Delinquency Survey, the seasonally adjusted delinquency rate for mortgage loans
on 1-4 unit residential properties stood at 6.35% of all loans outstanding at
the end of 1Q 08. The figure represents a 53-basis-point increase from the
delinquency rate in 4Q 07 and a 151-basis-point rise from that in 1Q 07. The
percentage of loans on which foreclosure actions were started during 1Q 08 was
0.99% on a seasonally adjusted basis, 16 basis points higher than that in 4Q 07
and 41 basis points higher than the 1Q 07 levels. The rising delinquencies in
mortgage loans are likely to compel the bank to increase its loan loss
provisions in the coming quarters. Any such development could dent its bottom
line.

Adding to the problems, on the macroeconomic front, the unemployment
rate surged to 5.5% in May 2008, the largest monthly rise in more than two
decades. The increase in unemployment rate reflects the recessionary situation in
the US. It points toward the reluctance of US companies to hire new recruits,
as the consumer spending slowdown and soaring oil and raw material costs
squeeze profits. The major concern behind a weaker labor market is that consumers
will restrict their spending, which is likely to have a negative impact on corporate
profits. Consumer spending is the force behind the growth in the US economy.
Therefore, a surge in unemployment rate portends lower spending power for consumers
in the US and (coincidentally) lower consumer debt service capacity as well as
(consequently) lower corporate debt service capacity; resulting in higher
defaults for both consumers and corporations.

Net interest income growth to be
restricted in coming quarters

The bank’s net interest income has been under pressure during the last few quarters due to the poor performance of its loan portfolio that mainly comprises real estate and housing related assets. The bank’s net interest margins benefited from the
lowering of the benchmark interest rates by the US Federal Reserve in the last few quarters. Wells
Fargo’s net interest income grew 15.0% y-o-y to US$5760 million in 1Q 08. Going forward, considering Wells
Fargo’s significant exposure to the home equity and real estate construction
sectors in the troubled markets,
the bank’s loan portfolio will likely be under pressure. This factor could dent growth in its net interest income in the coming quarters.See “The Anatomy of a Sick Bank!” for an overview of net interest margins in “Reggie Middleton’s Doo Doo
Bank 32” list, of which Wells Fargo is a prominent member.

Net interest income and
growth (%)

Source: Company data

Rising defaults in home equity
portfolio could result in higher losses

During the housing boom, Wells Fargo expanded its real estate portfolio
and avoided making option Adjustable Rate Mortgages (ARMs) or negative
amortizing loans. Despite avoiding these riskier loans, Wells Fargo’s home
equity portfolio is deteriorating due to rising defaults and declining home
prices. Consequently, the bank segregated US$11.5 billion of home equity loans
into a liquidating portfolio, representing approximately 3% of total loans
outstanding in 1Q 08. These home equity loans that are concentrated in the
California, Florida and Arizona markets accounted for a significant portion of
credit losses. The liquidating loan portfolio is mainly confined to geographic
markets that have witnessed the steepest decline in home sales and housing
prices. The liquidating portfolio resulted in an annualized loss rate of 5.58%
for 1Q 08, compared to 1.56% in the remaining core home equity portfolio.

Wells Fargo’s home equity losses are concentrated in the third-party
correspondent channel. Approximately 55% of the liquidating home equity
portfolio of US$12 billion has a combined loan to value (CLTV) of 90%. Such a
high LTV will likely result in major losses for the bank in this liquidating
portfolio. The core home equity portfolio was worth US$72.1 billion in 1Q 08. Of
this, approximately 45% of the exposure was in the states of California,
Florida and Arizona (36%, 4% and 5%, respectively), representing nearly
70% of the bank’s shareholders’ equity. The worsening housing
scenario in these markets as prices continue to tumble and defaults rise, is
expected to result in higher losses in the near future.

Home equity portfolio – geographical breakup

Source: Company data

Credit card defaults to rise with
increase in annualized charge-off

In the last few years, as the US economy prospered and reported strong
GDP growth, Wells Fargo’s credit card loan portfolio expanded at a CAGR of
22.3% to US$19 billion. However, the subprime mortgage bubble burst triggered
an economic slowdown amid inflationary fears, increasing stress as well as
defaults in the consumer finance segment. The charge-offs to loan ratio in Wells
Fargo’s credit card segment rose to 1.68% in 1Q 08 (annualized 6.7%) from 1.25%
in 1Q 07 and this trend is anticipated to worsen, going forward. As outlined
above, the deteriorating macroeconomic environment in the US is likely to
increase charge-offs in the credit card segment. As US consumers are burdened
with higher gasoline and food prices, and as unemployment increases, the
default on borrowings is likely to rise. The delinquency rate of the top 100
banks in the credit card business increased to 4.84% in 1Q 08 from 4.06% in 1Q
07.

Wells Fargo’s Credit Card Loan and Charge-offs

Source: Company data

Provision for losses to rise as bank
has significant exposure to distressed asset class

Wells Fargo has been under provisioning for its credit and loan
exposure for almost a decade now. The bank’s provisions for losses have not
kept pace with the growth in its loan portfolio. Wells Fargo’s allowance as a percentage of loans declined
from 2.86% in FY 1998 to 1.18% in FY 2006. The bank’s loans increased at a CAGR
of 14.3% in the last nine years to US$382 billion, while the provision for
losses expanded at a CAGR of 5.5% to US$5.3 billion. In the last few quarters,
the bank has increased its provisions to counter the rising losses in the home
equity and real estate construction portfolios. However, this may not be
sufficient to take care of the anticipated rise in losses from real estate,
construction as well as consumer lending.

Wells Fargo announced a US$1.4 billion pre-tax special provision in 4Q
07 due to higher loan losses from home equity loans made through certain
indirect channels. The bank also added US$0.5 billion of reserves in 1Q 08, in
excess of charge-offs, to cover home equity and small business loans. This
development indicates that credit problems are now spreading to other
businesses. The bank is required to expand its US$1.9 billion reserves built
over the last two quarters to address the ongoing decline in the real estate
and housing markets.

Charge-offs and allowances as a % of total loans

Source: Company data

Wells
Fargo changed its home equity charge-off policy from 120 days to no more than
180 days, or earlier if warranted, from April 1, 2008. Although the bank states that the shift
would help in
assisting customers, it appears that Wells Fargo is trying to delay the charge-offs from being
reflected in its books.The bank claims that in a challenging real estate market, more time is required to work with customers to identify ways to resolve
their financial difficulties and keep them in their homes.
However, we believe the bank is
trying to hide its losses in the home
equity portfolio and put off provisioning to a future date, thus smooth earnings and loss rates.

Higher provisions are likely to dent the bank’s profitability. As
losses on its home equity, commercial and construction loans continue to mount,
the provisions are expected to rise in the near future.

Allowance and Loan growth

Source: Company data

NPAs and charge-offs continue to
rise

The bank’s NPAs increased 22% q-o-q to US$3.3 billion in 1Q 08. On a
y-o-y basis, NPAs grew 86%. NPAs as a percentage of total loans rose from 0.54%
in 1Q 07 to 0.84% in 1Q 08 due to deteriorating real estate construction and
home equity portfolios. The growth in NPAs is driven by declining value and
rising defaults in real estate mortgage loans. In 1Q 08, Well Fargo’s NPAs
(including foreclosed assets) increased to 1.16% of total loans from 1.01% in
4Q 07 and 0.82% in 1Q 07. The bank’s total NPAs grew to US$4.5 billion from
US$3.9 billion in 4Q 07. The growth in NPAs in real estate construction was
exceptional, 49.5% q-o-q and 434% y-o-y to US$438 million.

NPAs in real estate construction loans stood at 2.32%, followed by NPAs
in real estate 1-4 family mortgages (1.91%) and lease financing (0.83%). NPAs
are anticipated to rise as the bank liquidates its troubled home equity
portfolio in view of declining housing prices and rising defaults.

Wells Fargo’s net charge-offs totaled US$1.5 billion, representing
approximately 1.60% of average loans, significantly higher than 1.28% in 4Q 07 and
0.90% in 1Q 07. Charge-offs in home equity, real estate constructions, other
mortgage and credit card loans increased significantly due to rising defaults,
declining home value and deteriorating credit conditions. Commercial and
commercial real estate charge-offs increased to 0.19% in 1Q 08 from 0.11% in 1Q
07. Expressed as a percentage of consumer loans, charge-offs in consumer loans
rose to 0.63% in 1Q 08 from 0.39% in 1Q 07.

Growth in non accrual
loans

Source: Company data

Decline in mortgage banking, credit
card fees to drag non-interest income down

Non-interest income contributed approximately 56% to the bank’s total
revenues in 1Q 08. The non-interest income increased 8.4% y-o-y to US$4,803
million in 1Q 08 on account of growth in service charges and credit card fees, and
US$636 million gains on debt securities and equity investments. The bank
derives 25% of its non-interest income from the mortgage banking and credit
card businesses. Income from mortgage banking declined 24% q-o-q and 20% y-o-y
to US$631 million in 1Q 08. The fair value of the bank’s Mortgage Servicing Rights
(MSRs) has been on a downtrend, decreasing to US$14.9 billion in 1Q 08 from US$17.8
billion in 1Q 07. The bank’s income from mortgage banking will depend on
changes in the fair value of MSRs and whether or not the bank is adequately
hedged against such movements. Considering the current state of the housing
market, it is highly likely that the bank’s income from mortgage banking will
be severely impacted in the coming quarters. In addition, the income from
credit card business declined 14% q-o-q to US$499 million. Charge-offs in the credit
card business grew significantly in 1Q 08, reflecting increased pressure on the
credit card business.

Going forward, as macroeconomic conditions worsen, the strength of
Wells Fargo’s credit card business will be tested. Consequently, we believe the
decline in mortgage banking activities and the credit card business will
negatively impact the bank’s non-interest income.

Growth in non interest
income

Source: Company data

Key assumptions

Net interest income to
remain flat

We anticipate the bank’s net interest margins would remain flat over
the period, as Wells Fargo’s loan portfolio, considering its significant
exposure to the troubled mortgage market, is expected to weaken. Consequently,
the interest income earned on this real estate mortgage portfolio would remain under
pressure in the near future. However, the 3.25% reduction in the benchmark rate
by the US Fed since September 2007 has helped the bank’s financials. As the
cost of borrowing comes down, we expect the bank to enjoy a higher spread in
the near-to-medium term on account of strict lending practices. The mandatory
caveat here: the US and world’s central banks are under increasing pressure to
raise rates due to global dissatisfaction with the weak dollar and sharp spikes
in inflationary pressures. Though deposits will likely be mobilized at a lower
rate, considering the troubled loan portfolio (high real estate exposure) and
lower loan growth, we expect the margins to worsen or remain unchanged, going
forward. There is very little, if any, room for any additional improvement in
margins, which bodes ill for a company whose balance sheet is rife with
depreciating assets swimming in a hazardous macro environment.

Loan growth to slow down as
macroeconomic conditions worsen

The deteriorating macroeconomic conditions in the US and the ongoing
credit crisis in the financial sector are likely to significantly dampen the
growth in the loan books of banks. The rising defaults witnessed across several
banking products, such as mortgages, credit cards, auto and student loans, are
likely to pull down growth in loans in the near-to-medium term. The adoption of
stricter lending practices by banks in the aftermath of the credit crisis would
also halt loan growth. Wells Fargo’s commercial loans, which consist of 35% of
real estate mortgage and construction loans, are likely to take a big hit. The
ongoing meltdown in the mortgage market, with its repercussions in the
construction and real estate sectors, is expected to decrease the demand for
such loans. In addition, growth in consumer loans, which largely comprise 1-4
family first mortgages and 1-4 family junior lien mortgages, is likely to
decline in the near term. The increase in the unemployment rate, rise in job
cuts and a weakening macro environment are expected to lead to increased
defaults in the credit card segment. Therefore, we expect credit card loans to grow
at a slower rate in FY 2008 and FY 2009.

The bank’s deposits are likely to expand in FY 2008, considering the
growth in its retail core deposits in 1Q 08. However, the decline in interest
rates would also restrict deposit mobilization activities. Therefore, we expect
growth in the bank’s deposits to slow down in FY 2009 and pick up thereafter.

Charge-offs, provisions to
rise on account of exposure to troubled portfolio

The slump in demand in the housing market and the ongoing price
correction would continue to result in higher charge-offs in the commercial and
consumer loan segments. Wells Fargo marked approximately US$12 billion of home
equity loans into a liquidating portfolio in 4Q 07 but further reduced it to
US$11.5 billion in 1Q 08. The liquidating portfolio resulted in net charge-offs
of US$163 million in 1Q 08, representing an annualized quarterly loss rate of
5.58%. Problems in the credit card business could also contribute to increased
charge-offs in the consumer business.

The bank has been under provisioning for a long time now and may have
to increase provisions for credit losses in the light of the mounting losses in
its mortgage and home equity portfolios. Despite the strong growth in its loan
portfolio and overall asset base, the provisions (and allowances) have not kept
pace with the growth in lending. In our opinion, the bank’s loan portfolio would
come under severe stress, making way for higher provisions.